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A Shift in Oil Extraction?

Major oil companies are shifting their petroleum extraction from land to sea in the hopes of mitigating risk

Oil extraction in Africa has always been a risky business. Many oil exploration and production (E&P) companies have had to contend with the issues of corruption, human rights violations, and the sheer hostility of the environment. All too often the most profitable oil and gas fields tend to be in the middle of a desert or jungle. Typically these places are not overly inhabited due to the hostile nature of the environment. The extreme temperatures, and the high humidity often wreak havoc on the infrastructure and the machinery.

Risk mitigationOil companies often seek to mitigate as many risks as possible during drilling operations. Maintaining local government support, which often ensures the enforcement of rule of law and as few disruptions as possible in the supply chain is essential for predictable flow to market. Without a local government that is able to enforce the will of the government a degree of risk begins to grow. The recent protests around Eni(NYSE:E) liquid natural gas points in Libya is just the most recent example of the effects of a week centralized government. Yet, Eni is not alone in this occurrence as its fellow European oil company Royal Dutch Shell(NYSE:RDS-A) shares similar problems in Nigeria.

In early November protesters blocked the Mellitah natural gas terminal. Italian oil company Eni owns this terminal, and the LNG was destined for an Italian market. Paolo Scaroni, CEO of Eni, is warning that such protests could stop LNG exports to Italy.

On November 11 another protest occurred around an LNG point in Libya. Protesters from the Amazigh minority have shut off Libya's Greenstream natural gas export pipeline to Italy. ENI owns and administers the Western Libyan Gas Project that includes the Greenstream pipeline and the Mellitah natural gas terminal through Mellitah Oil and Gas, a joint venture with Libya's National Oil Company. Greenstream is the longest submarine pipeline in the Mediterranean.

Western Libyan Gas Project Map

The problemIn post-Qaddafi Libya a power vacuum exists; law and order appear to be at times more inconsistent than they were under the totalitarian regime. These recent protests have halted a crucial commodity for the Libyan people. Such events reflect the ever-present risk factors that surround the E&P industry. With little or no central government or ability to enforce regulations and rule of law -- this type of banditry could become all the more common.

The problems Eni is facing in Libya are not that much different from the problems Royal Dutch Shell has been facing in Nigeria. In both countries ethnic minorities have formed clans, and these clans often form militias or political groups to represent and protect their interests. These clans are quasi-governmental factions -- they essentially pose a greater threat to the legitimate governments in power. The asymmetric nature of these groups often allows them to succeed at usurping authority and undermine efforts that are designed to benefit the nation as a whole rather than specific groups or clans. Eventually, the situation erodes to a point where the nation must take drastic action through law enforcement or military action to neutralize the power of those groups. If this measure is not successful, industrial interests often pull out, causing unemployment, and government authority erodes entirely.

Royal Dutch Shell recently closed off the Trans-Niger Pipeline, citing security concerns and technical problems. It has had long-standing problems with MEND and other lesser militant factions that often steal oil directly from pipelines or terrorize workers from foreign oil companies.

A solutionNigeria's still has a great deal of oil wealth. Royal Dutch Shell and other oil companies have not given up on their operations. Rather, they have shifted focus to offshore operations. The benefits of offshore operations are primarily security, predictability, and control. These three factors are often at risk when critical infrastructure such as pipelines or refineries are in the middle of hostile environments. While offshore operations are not a perfect solution, it is a more profitable one and one that can be controlled.

Will Investors be willing to...The looming question that must be asked by investors is whether it's necessary to put up with the uncertainty and risk, which translates into greater costs and often less supply from land operations, or whether it's more profitable to invest in offshore operations.

CNOOC(NYSE:CEO) is one of the larger majors in the oil industry. Throughout the 1990s it circumnavigated the globe with pipelines, refineries, and drilling operations with the support and approval of the Chinese government. Many times local government politics and atrocities were linked to the presence of CNOOC. All this began to reaffirm one fact: the realization that the cost of doing business in developing nations is very high in both reputation capital and currency. The recent move from onshore operations to offshore operations in the South China Sea is evidence of a growing technological capability to extract petroleum products at depth and the lack of corporate will to tolerate the common risks encountered from onshore operations.

More E&P companies are turning to the seas with the hope that breakthroughs in drilling technology will make accessible the last remaining pockets of oil that are at ever increasing depths.